Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

APPENDIX 3A: THE FIRM’S COST OF CAPITAL

The cost of capital is the rate of return that a firm must earn to satisfy its suppliers of capital—debtholders and shareholders. The term “cost of capital” is a source of confusion, however, for several reasons. First is the issue of whether what is being referred to is the firm’s overall cost of capital—that is, the cost of capital for all of the firm’s projects (past and present)—or the cost of capital for a specific project. The former is used in performance evaluation techniques, and the latter is used in capital budgeting applications for individual projects. In the latter case, a project’s cost of capital is generally determined by first starting with the firm’s overall cost of capital and then tailoring this value to reflect the project’s relative riskiness.

Another source of confusion is whether what is being referred to is the marginal cost of capital or the embedded cost of capital. The marginal cost of capital is the cost of capital for raising the next dollar of capital. The marginal cost of capital is used in capital budgeting situations when evaluating whether the project’s future cash flows outweigh the cost of the funds to support those cash flows. The embedded cost of capital is the cost of funds already raised—that is, what it costs the firm for the funds already supplied. In performance evaluation, an embedded rate is used because a specific period is being examined to see whether the firm created value during that period. ...